The High Cost of Inaction
- Nov 01, 2017
It’s common knowledge that buying assets at the wrong time, for the wrong price, can be a very expensive mistake. After all, if you “make your money when you buy,” you’d better buy right. Right?
At the same time, there is a high cost in not buying an asset. Passing on a deal for a few points of near-term return and “keeping your powder dry” for a better opportunity can be more expensive than it seems.
However, if you don’t move forward with an opportunity, you still have your money and can invest it in the future. That decision carries a significant opportunity cost because you lose the chance to have that money working for you in real estate as opposed to earning little or no interest in a safe harbor investment. Given the wide difference between total returns in investment real estate and yields on low-risk or risk-free investments, simply missing one year of the return on a real estate investment can have an outsized impact, even over a multi-year period.
Consider a 7 cap rate property, purchased with 30 percent down and a 5 percent loan, amortized over 25 years. Figuring 2.5 percent annual increases in rent and expenses and a 7.5 percent terminal cap rate, this property generates a 12.9 percent internal rate of return over a seven-year holding period. While this might not be an aggressive return, it is a realistic one for a cash-flowing asset.
Simply waiting one year to make the same investment reduces your internal rate of return to under 10.2 percent, as long as you truly compare the two investments equally. In the first case, you buy real estate and hold it for a seven-year investment period. Waiting a year, though, means you are effectively buying a risk-free liquid investment for a one-year period—like a one-year treasury bill (yielding 1.4 percent as of this writing in late October)—then holding the commercial real estate asset for six years. This means you end up with one less year of rent collection, rent growth and principal reduction. These last two factors take the impact on cash flow and expand it into decreasing the proceeds from the eventual disposition of the asset. All of that adds up to a 25 to 30 percent reduction in your total return over the life of the investment.
We know what it costs to buy a piece of investment real estate. But do we think about what it costs to not buy? When the right property isn’t available, hesitation is a prudent strategy. But when the right property is available and the price is a little high or the terms of the transaction have a hiccup, the costs of those unpleasant surprises could easily be significantly less than the cost of waiting for the perfect property to come along. Before walking away from a deal or a transaction in process, make sure you know everything that you are giving up.